Behavioural Finance and the Efficiency of Capital Markets

Masters
Essay
Business
Pages 11 (2761 words)
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Robert Shiller, a Yale economist, has long argued efficient-market theorists made one huge mistake: 'Just because markets are unpredictable doesn't mean they are efficient. The leap in logic, he wrote in the 1980's, was one of the most remarkable errors in the history of economic thought.' Mr…

Introduction


All the literature on market efficiency defines an efficient market as one where prices reflect all available information and sellers cannot earn windfall profits in a sustained manner (Fama, 1970). Large profits can be earned only by having inside information that is not publicly known and trading based on such information, or through misinformation; both are illegal.
In an efficient market, assuming all companies disclose information to investors, only those who enter the market first may earn above average returns. Just like any other market, the one who arrives first can buy at a lower price and then, as demand goes up, sell at a higher price.
This logic that consistently beating the market is not possible led to the creation of index funds that mimic the market's performance. Nevertheless, small investors unaware of these academic and empirical discussions continue to try to beat the market, only to incur expenses on fees and commissions.
Behavioural finance proponents think that market-beating strategies exist and that a careful analysis of historical price trends and financial reports can pay off (Shiller, 1990). They point to stock market anomalies and other forms of market inefficiencies that allow investors to reap above average returns.
He claims that conclu ...
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